Yellen says rules might need to be strengthened further to bolster largest banks

WASHINGTON – The Federal Reserve may be about to turn more aggressive in its regulation of the financial system.

Fed Chair Janet Yellen suggested Tuesday that current regulatory rules might not be enough to prevent the kind of risk-taking that triggered the 2008 financial crisis and nearly toppled the entire banking system.

She said the largest U.S. banks may need to hold additional capital to withstand periods of financial stress. Non-banks with deep reaches into the financial system might also need to meet tougher rules, she said. Such firms range from money market mutual funds to private equity and hedge funds.

Yellen told a banking conference in Atlanta that current rules on how much capital banks must hold to protect against losses don’t address all threats. The Fed’s staff is considering what further measures might be needed, she said.

At the same time, Yellen said the Fed would review the likely effects of imposing stricter rules on banks. Banks and their advocates have warned that further tightening bank regulation would lead to reduced lending to businesses and financial institutions and could slow economic growth.

Analysts said Yellen’s message echoed remarks that Daniel Tarullo, a Fed governor and the board’s point person on bank regulatory issues, has made in the past. They said it could be a sign that the Fed under Yellen will take a more assertive stance toward bank regulation.

In her speech, Yellen said further actions to address risks, such as requiring firms to hold more capital, would likely apply only to the largest, most complex banks. But she suggested that other requirements could be applied more broadly to medium-size banks and non-bank financial institutions.

Karen Shaw Petrou, an analyst who heads Federal Financial Analytics in Washington, said Yellen also appeared to be signalling a desire to ensure that in tightening rules for big banks, regulators don’t just drive risky behaviour into less regulated areas of the financial system. These areas are often called the shadow banking system.

“The threat is if all you do is regulate the big banks, the risk will move to the non-banks,” Petrou said. “Yellen is signalling that the Fed will seek to address that problem.”

Bert Ely, an independent banking consultant in Alexandria, Va., said Yellen was indicating that the Fed plans to address the risk that parts of the financial system will exploit gaps in the rules.

“The more requirements you put on the highly regulated banks, the greater is the incentive to find ways around the tougher rules,” Ely said.

In 2007 and 2008, risk-taking in a corner of shadow banking known as subprime mortgages spread to other areas of the system and eventually pushed the country into the worst recession since the Great Depression.

In her remarks, Yellen said regulators must focus on ways to prevent another financial crisis. She spoke via video to a financial markets conference sponsored by the Fed’s Atlanta regional bank.

“In 2007 and 2008, short-term creditors ran from firms such as Northern Rock, Bear Stearns and Lehman Brothers and from money market mutual funds and asset-backed commercial paper programs,” she said. “Together, these runs were the primary engine of a financial crisis from which the United States and the global economy have yet to fully recover.”

Yellen referred to a 2010 study by the Basel Committee on Banking Supervision. The study, in assessing the long-term economic effects of imposing stricter capital and liquidity requirements on banks that operate globally, concluded that such changes would produce a net economic benefit.

“While it would be a mistake to give undue weight to any one study, this study provides some support for the view that there might be room for stronger capital and liquidity standards for large banks than have been adopted so far,” she said.

Last week, regulators approved requirements that will make the eight largest U.S. banks add up to $68 billion in capital to comply with rules designed to ensure that the banks could withstand severe losses.

The so-called leverage ratio approved by the Fed and the other regulators will require the largest banks to maintain capital well above the global minimum levels against all assets on their books, not just those judged to be the riskiest.